Good Fences

Living in a modern apartment complex in a big city usually means knowing little to nothing of the people around you. I have neighbors on both sides of me and all I know of them is tiny little stuff based on hearing their interactions in the hall as they and their guests enter and leave the apartments. And, of course, on the rare sound heard through the walls.

The sound heard through the walls is rare because the walls between apartments in my building are thick. Like slow-witted-cashier thick. Often you can clearly hear somebody's TV turned way up from the hallway but find only blissful silence once ensconced in your own living space.

So what have I learned about my neighbors? Odd things. I'll take the one I think is less interesting first.

The apartment to the East of mine is a large one-bedroom situated on the corner. I know this because I took a surreptitious look around when they left the door open when repairing it between tenants a couple of years ago. The fellow who lives there is a tall guy. He has a large dog (black lab, I think, though I'm terrible with dog-breeds). He has a standing order for two cases of the sports-sized Poland Springs bottled water, which appear outside his door in the early morning once a month.

He went to Ohio State and I think he has a job that allows him to work from home much of the time.

The Ohio State factoid I learned shortly after Georgetown beat UNC Vanderbilt (thanks for the reminder Bill) in the NCAA tournament the year before last. I had watched the game at home with a few friends and when Green sunk the game winning shot as the final seconds ticked off the clock there was an understandably boisterous celebration. Boisterous enough, I suppose, to actually penetrate the sound-suppressing walls that my apartment is blessed with. We later went on to beat UNC which meant we would next face Ohio State in the Final Four. The evening after that win I returned from work to find a note from my neighbor taped to my door congratulating me on Georgetown's win and wishing us luck against Ohio State signed "An Ohio State Alum" with his apt. number given.

The working from home I am hypothesizing based on the fact that he orders food in every night at roughly 6:30. As I get home in the 6-ish range this would imply that he either gets home just before me and immediately orders dinner or that he is just home all day. My rare experience with being home sick or otherwise during the week seems to confirm the home-all-day theory.

So that's my Eastward neighbor.

My Westward neighbor is, I am fairly certain, a prostitute. I'm not sure if she is the same woman who has lived there for the past two to three years or if she is of newer import. (I haven't actually seen her since I began to suspect her working-girl status.) However, she routinely receives many, many visitors in the evening. This alone is perhaps suspicious but not proof of working-girl status. Nor are the many candles she lights which I can see reflected in the windows of the building across the alleyway.

Last Tuesday evening, however, I ran into one of her visitors on the elevator. He was a 40-something guy, who I had never seen before, heading for my floor. Nothing suspicious in that, I haven't seen lots of folk who live on my floor. He was polite, holding the door for me as I was carrying armfuls of stuff. Getting off the elevator, he again held the door for me and followed me out.

He headed with me towards my door. There are three other doors in that direction: my Ohio State friend, the supposed-prostitute and a currently empty apartment. Getting close to my door, he was looking at the numbers and asked me if the prostitute's door was F. I acknowledged it was and bid him "have a good night" as I was just finishing opening my door and stepping inside. His reply "I'm working on it" drew my notice to the fact that he was carrying a bottle of wine in the bag from the wine store around the corner. Given that he was a 40-ish guy and she is (based on late-night comings and goings and the timber of her female friends voices) a 20-something, it seemed odd that they would be meeting up for a date. It seemed even odder when that date ended somewhat less than an hour later and he went on his merry way.

And that, dear friend, is why I am firmly convinced that my next-door neighbor is a prostitute.

It's in Belgium.

So a ways back, when the sun yet shone, before the dark times, before... The Bailout, I took a trip to Florida.

We took some Netflix with us. One of those movies was a little oddball comedy that had intrigued me since I had first seen its trailer but, like most movies, I never got around to seeing in the theater or in the first few months of its DVD release.

This was In Bruges.

I am happy to report that I enjoyed it. I should start by saying that I was surprised to even be intrigued by it way back at first viewing of the trailer as Colin Farrell has a long history of making awful, awful movies. Just awful. I'm not actually sure why he's a movie star because in addition to being awful, I'm under the impression that many of his movies don't make money.

You'd think that making bad, expensive, money-losing films would be a career-ender but the ways of Hollywood are mysterious indeed. Maybe I should get a job in that industry next, work my death-touch magic on those big bags of useless.

Anyways. In Bruges.

Very odd movie. Reminded me of a play in that it had very tight dialogue and a fairly intricately woven plot that didn't actually go very far but kept circling over on itself and putting in clever little references to earlier seemingly throw-away lines so that the whole thing ended up being very enjoyable indeed.

I should point out, before everyone goes rushing out to rent it on my good say-so, that it was a very dark and fairly violent comedy. I'm not sure that most people would like it. My girl, for example, was not as taken with it as I was, though she enjoyed it as well.

She particularly liked a certain line of Ralph Fiennes that was very reminscent of a joke I use far too often. If you know me you will likely recognize the joke when you see it in the movie. (Though his character is not using the line in a joking manner, it is clearly a joke in the overall movie.)

I give it three stars. Good flick.

Coherence. I think it's over-rated but who am I?

Here's a run-down of the AIG bailout that doesn't read like the ramblings of a drunkard sometime after 3 am. If you like that sort of thing.

Clearly, I prefer unfinished, multi-part ramblings that more than passingly resemble drunk-talk. Or else why would I keep posting them, right?

Oh, don't despair. I've got some words on old movies that I finally watched and crazy boring econ books I've recently read coming up too. It's just that I've been rather distracted by the tremulous fate of my company and the finance system more broadly of late.

Part 7: Everybody in the Pool!

So now we've got lots and lots of marginal people getting mortgages that they prob. shouldn't have, structured in ways that make it very unlikely that they'll be able to pay them off -- partly because of wide-eyed optimism and hopeful thinking on the part of the government, mortgage lenders and the people themselves and partly because of fraud by mortgage applicants and sellers. Regardless, everybody's fine so long as housing prices keep going up...

Then you have all of these mortgages gathered together into massive mortgage backed securities. These have been given quality ratings by the rating agencies -- partly because of fraud-ish greed on the part of the raters and securitizers and partly because, with housing prices going up, they don't look that risky. And so long as housing prices keep going up, they won't be that risky.

Everybody see where the problem is? Everything is predicated on housing prices going up. But that is predicated on an ever expanding group of people to buy these houses. But we've already come up with shady mortgage structures and tossed out the standards just to get to this point. Where are the buyers going to come from to continue propping up these prices?

The answer, of course, was nowhere. And thus housing prices stalled and declined. And, suddenly, these people who took out the ARM and other loans with payments that jump are facing high new rates and a house that's worth less than they borrowed to buy it. And, of course, it's a chain reaction of sorts. A foreclosure in the neighborhood lowers housing prices which traps still further people in the same boat.

So that's what's going on in the neighborhoods. Bad things. People not being able to afford their payments. People watching their house's value decline precipitously.

But what's going on down the line with the securities backed by all these mortgages? Also bad things.

See, for years companies were making a killing on these things. So, naturally, more and more companies got in on the game. They would buy these mortgage backed securities to hold for themselves. Which means that on their balance sheets, they would have an asset that was backed by all of these securities. And that asset would have a value. So what's the value of that asset? Simple, it's whatever you can sell if for.

Perhaps a bit of accounting arcana? You see, financial firms these days are required to use what's called "mark-to-market" accounting. This basically means that all of the various stuff (stocks, bods, mortgage securities, other derivatives, whatever) that comprises the assets of the firm must be valued each day at whatever they would be worth if you sold them all immediately.

Ordinarily this is not a problem. But it can set up nasty chain-reactions if there's a panic. So when the housing market stalled out, suddenly all these billions and billions of dollars of mortgage backed securities didn't look so hot. So lots of firms became eager to get them off the books. So they started selling them. A lot of them. All at once.

As I think most people can guess, when everyone tries to sell the same thing at once, the price crashes. And so the price of these things cratered. But, again, the firms have to record the value of these things as if they were selling them today. So when the price crashes, the value you record also plummets.

Which means, suddenly, you are not holding as many assets as you thought you were. Which can cause all kinds of problems. The credit rating agencies, yes, those same agencies that told you this garbage was AAA-rated, might look at your newly weakened balance sheet and slash your credit rating. Which would then cause all the firms you do business with to ask for more collateral. Which means you need to come up with money fast. But, since your credit rating has been slashed, it's harder for you to borrow at just the time you most need to. So you might well go under.

This is all much more likely to happen if you happen to be a highly leveraged firm -- which all of the investment banks were. Leveraging is a fun and useful concept but I won't get into it here. Just to say that it's been at the heart of every financial collapse, prob. in history. As with everything else, this does not mean it's a bad thing. After all, the internal combustion engine has been at the heart of every traffic disaster and it is a wonderful thing.

At any rate, this is roughly the position that Bear Sterns found itself in. It was facing bankruptcy because the value of the mortgage backed securities that it was holding were plummeting because everybody was selling them and nobody was buying them.

So why was it saved by the Fed? Simple, the Fed gambled that if it could prevent Bear from going under suddenly, it might nip this whole thing in the bud. You see, if Bear had dropped suddenly into bankruptcy, all of its assets would be sold off very, very cheaply. Which would mean that all of the other investment banks holding those assets (we're primarily still thinking of the huge mortgage-backed positions these banks held) would also have to value them at the very cheap price. Which would put more of them into the same boat as Bear, just as surely as a domino knocking down another domino.

Ignoring, for the moment, the Fannie and Freddie stuff, the very same thing played out later with Lehman and AIG. Lehman was allowed to go under because the Fed saw that their bet on Bear hadn't worked and decided they needed to let somebody fail to remind the market that there's no such thing as a free lunch. But this decision ended up having precisely the effect that they were hoping to avoid with Bear: Lehman's bankruptcy meant that their mortgage-backed securities book was suddenly valued much lower.

AIG had a sizable book of similar assets whose value was thus immediately slashed. But it also was among the largest writers of "credit default swaps" (CDS), which basically functioned like insurance on these mortgage backed securities: that is, other firms would enter into a CDS with AIG that basically stated if the value of the mortgage backed securities the firm was holding dropped, AIG would make up some of the difference.

So two things happened so far as AIG was concerned when Lehman failed: its own book of mortgage backed securities was suddenly slashed in value and the potential costs of honoring all of those CDS's suddenly became much higher, at least as of the current valuation. (Again with the "mark-to-market" stuff.)

This did not sink them. What did was that with these developments and probably fearing that their reputations had been harmed by having their fingerprints all over these sub-prime mortgages securities the big three rating agencies decided to get tough. So they immediately threatened to downgrade AIG's credit, which meant that AIG would have to immediately come up with a lot of money. And come up with that money in a market that was skittish and using a credit rating that was lower. Not possible, AIG would go bankrupt trying.

So why did the Fed save AIG? Precisely because of all of those CDS's. You see, all of the banks with large amounts of these mortgage backed securities could avoid valuing them super-low so long as they had these CDS's on them. Going back to the insurance analogy, they could say: "Yes, we have these mortgage backed securities that are collapsing in value. Last year they were worth $100B now they're worth only $35B. But! We have agreements with AIG that limit our losses to $30B, so we are valuing them at $70B." But if AIG goes away, all of a sudden the full loss has to be recognized. Pushing all of those banks closer to the edge, if not over it.

The thing with Fannie and Freddie is a whole other kettle of fish so even though it took place in between the Bear bailout and the Lehman/AIG fiasco, I'll deal with it separately later...

The Great Collapse Part 6: Living on a Prayer...

Everybody have a good weekend? Good. Me too. Everybody forget where we were in the story of the Great Collapse? Good. Me too. So perhaps a recap...

In Part 1, we gave the thumbnail version that the collapse was primarily predicated by the Housing Bubble. We talked a bit about what a bubble is and what the characteristics of that bubble were. We only just mentioned that the Federal government was interested in more people buying houses but didn't go into great detail about the various players and reasons for the decade-long run-up in housing. Perhaps we'll discuss that in Part 6.

In Part 2, we took a stroll down memory lane and talked a bit about what a mortgage is and how they traditionally worked. That led us to...

Part 3, where we looked at the dawn of Fannie Mae and Freddie Mac and the government getting into the mortgage market in a huge way. But that was only the prelude to the real fun which was...

Part 4 where we look at the development of mortgage securitization and the enormous new pools of money that opened to the mortgage market. But to sell to those new investors you'd need someone to sign off on the quality of your mortgage backed products which got us to the first of the serious problems which was discussed in...

Part 5, where we looked at the conflict of interest driving the ratings agencies to rate these sub-prime-backed mortgage securities perhaps more highly than an objective rater might.

So. Now we're all caught up. So how on Earth did we get to the point where there were so many sub-prime mortgages getting balled up to sell? Well, this is kind of back to the housing bubble story but now that we know how things flow, we can kind of get into details.

There are a lot of groups involved and interested in increasing home ownership. Or maybe not even home-ownership, but just mortgage buying.

First, you've got the government. The rate of home-ownership in the United States had been stuck for years at about 64% or so. This was considered awful. So the Clinton and Bush administrations took it upon themselves to increase this. And they did. All the way up to about 68% or so. Of course, unless human nature is changing or the nature of the economy is changing, all you are doing there is letting people who are increasingly less capable of exhibiting the financial restraint and intelligence that dealing with a mortgage and home-ownership requires, have to deal with it.

Second, you've got ordinary people who watch home-prices go up and up and want in. Perhaps you also have people who watch rents (especially on the low end) go up and up and want out. Of course, people who are having to deal with the low-end of the rental market are prob. not ideal candidates for the trials and tribulations of home-ownership, but we'll ignore that for the moment. (Lord knows everybody ignored it during the bubble...)

Third, you've got people who sell mortgages for a living. They like nothing better than selling more and more of them.

Higher-up on the food chain, you've got the guys packaging and selling mortgage backed securities. More mortgages equals more securities equals more money. Yay!

So how does this play out in the real world? This is going to sound mean, but not everybody is cut-out for home-ownership. Certainly not everybody is cut out for it at any time. It takes a level of financial responsibility and, yes, intelligence that not everybody possesses and maybe even not everybody can possess.

So what this means is that you have some people who are solid locks. Rich, organized, smart, whatever, they are good to go with buying houses. As you head away from these rock-solid people, you go through people who are increasingly less solid purchasers and eventually you get to the 64% level that we've been at historically. At this level, not everyone is a rock-solid purchaser. There were defaults, there were foreclosures, just not a huge, huge amount. In fact, there were a pretty steady and stable amount.

As you push beyond that threshold, you are asking people who are less and less ready for the enormous responsibilities of home-ownership to step up. Ordinarily, the institutions that put up the money for these mortgages would balk at selling to them. But with the government breathing down your neck to increase your rate of mortgages to "disadvantaged" or other groups, maybe you're willing to chance it. When you can easily sell those mortgages off, you're much more likely to chance it. When it seems like a safe bet because house prices are going up, it becomes a lock! Best case scenario, these marginal people manage to keep the mortgage current. Worst case, they refinance with a new mortgage after their house goes up in value or you foreclose and sell the house for more than the loan. No problem.

So as the mortgage sellers dip further and further into the group of people that are prob. not in the position to responsibly handle a mortgage and as housing prices go up and up, you need to start throwing your lending standards out the window.

Traditionally, you needed 20% down to get a mortgage. And it had to be your money. This serves as a kind of test right there, because it takes a fair amount of financial planning and responsibility to get 20% of the value of a house saved up. Second, traditionally all of your financials had to be verified and documented. You had to prove that you actually made enough money to make the loan payments. And what's more, those loan payments couldn't be more than 30-36% of your pay. You couldn't, for example, have a mortgage payment that would eat up 50% or more of your pay.

All of these fairly sensible qualifications became more and more ignored as the bubble grew. People started taking out loans for the 20%, in effect borrowing the full value of their house. Thus they had no equity and even a slight price decline would mean their mortgage was more than the house it bought. Banks stopped verifying incomes and other financial documentation with anything like the diligence they should have.

Even still, you probably couldn't get enough people to take these loans. They would still be too expensive. So you start coming up with different structures. Interest only, wherein you pay only interest for the first so many years, thus lowering the payments. Or even, negative amortizations. Under these loans, you are actually increasing the amount you are borrowing for the first several years. You are, in effect, slowly going more and more in debt to the bank.

Or the famous Adjustable Rate Mortgages (ARM), these start off with a very low rate for a few years but then "adjust" to the market, which means the rate skyrockets. So unless the person's income skyrockets with it (unlikely, again we're dealing with the more marginal housing market participants here) they will have to refinance or sell the house. And there is often a penalty for refinancing or selling under these more "exotic" (read: "shady") loans.

So that's how people who prob. shouldn't have been taking mortgages were able to take out mortgages. And why they would take out mortgages that were structured in ways that made them riskier than traditional 30-year fixed rate mortgages.

Then these "sub-prime" mortgages would get balled together and taken to the rating agencies to get the stamp of approval and then sold off into the market.

And here's where it gets really, really fun...

Oh the Times we live with...

Yet another great one from the NY Times. This was in a front-page article on Saturday about the bailout plan. Sorry, I guess that should be Bailout Plan. So long as we're giving the Treasury Secretary $700B to play with and specifically saying there will be no oversight, we should probably capitalize, yes?

At any rate. In the course of giving a thumbnail description of where we are in the crisis, they mention "a mysterious colossus named the American Insurance Group."

Mysterious indeed as its name is actually the American International Group. To know that, of course, you'd have to have some kind of super powers. Well, that or 0.18 seconds and access to Google... Or, you know, just be marginally aware of the past week's biggest news. Whatever.

Honestly, the state of the Times these days is just embarrassing. I know they've been facing cutbacks but is firing all the copy-editors really the way to go?

The Great Collapse Part 5: Rate me, do it again and again, C'mon and rate me...

Alrighty then. We now have most of the basic pieces we're going to need to start constructing the financial shenanigans that got us to where we are. So now we start slotting them into place.

Last time, we looked at how Solomon had the revolutionary idea of slicing mortgage bundles into tranches in order to create more appetizing investments out of them.

But if I am an investor, how do I know which bonds are the good ones? And when Solomon or whoever wants to start selling pieces of one of these tranches (or, if I'm running a massive investment fund, perhaps the whole tranche all at once) how can I tell how good it is?

One way would be to do some heavy research myself. This would be costly and time-consuming. So, the market being what it is, a long time ago some folk had the bright idea to do the heavy research for you and publish lists of the results. Literally just lists of possible bonds and a rating for them, based on the research and opinion of these rating agencies.

These people were named things like Moody and Poor. The firms they started are still around, Moody's, Standard & Poor's and the other one are the big three. Yes, I could look up a reminder of the other one's name, but in groups of three isn't there always an "other one"? Like with the three tenors, or the three stooges, or whatever? (OK, fine. It's Fitch. Are you happy now? Fascist.)

So the big three rating agencies rate stuff. Companies, mostly. Which, in practice, means rating their bonds. Meaning rating how likely they are to pay off their obligations. They give grades like "AAA" or "AA-" or the like. So then investors looking to buy them know what an appropriate amount of interest might be.

Also, when making financial contracts between corporations, lots of times you'll have certain things be contingent on the credit ratings of the parties. Things like how much collateral you want to hold for them. In an insurance contract, say, for a large deductible policy, the insurance company often puts out the money for the deductible and then collects it back from the company later. Which means that the insurance company really wants to be sure the company will be able to pay. So they'll ask to hold some funds up front and the amount of funds will be highly determined by the company's credit rating by one of the big three. (This, too, will be very important towards the end of our saga.)

So the folk creating these tranches of securitized mortgages had the rating agencies rate them so they could sell them. And here, ladies and gentlemen, is a first part of the problem. The rating agencies are private companies trying to make money. They are also officially recognized by the government for their rating of companies. These two roles can be in conflict with each other. And were.

When these i-bankers started coming in with their snappy new tranche structures to be rated, the rating agencies charge them for the service. Obv. the banks are interested in better ratings. In theory, the rating agencies are interested in protecting their reputation for impartial ratings and doing a good job and all that. But they are also interested in money. Who's to say if you start rating a bank's mortgage securities too harshly they won't stop coming to you? Maybe they go to one of the other two rating agencies and you're left out in the dark.

So there's an incentive to rate them quickly and highly. (An excellent article on the rating of the sub-prime bundles by Moody's appeared in the NY Time's Magazine a while back.)

Once the i-bank has the rating on the mortgage backed security, they skip merrily off to market them to whoever is interested in that rating of debt.

Which would be fine if these things had been properly rated and were made up of standard mortgages taken out by qualified people.

But why would there be mortgages taken out by unqualified people? And who would try to sell bundles of questionable mortgages? These, dear friend, are questions for the next segment...

(To fully understand the title of this post it may be necessary to listen to the song "Rape Me" by Nirvana and also understand how vile I find the role of the rating agencies in this whole mess.)